The Securities and Futures Commission (SFC) has issued its first substantive statement on non-fungible tokens (NFTs) in a short release issued on 6 June 2022 (SFC NFT Statement).
In this alert, we summarise the following:
- The key messages in the SFC NFT Statement.
- Why they matter.
- Global developments in the NFT arena.
- Other observations based on our work in this area for several years.
Tip: For a primer on NFTs, please see our Guide to NFTs and NFT Marketplaces here. In this alert, we generally focus on NFTs that are tokens representing digital art and in-game assets unless otherwise specified.
SFC NFT Statement – what it says and why it matters
The SFC NFT Statement is the first of its kind in Hong Kong on NFTs, but one of a long line of similar crypto-related statements from the SFC over the years. A clear aim is to support consumer protection with risk warnings, while also acknowledging the boundaries of current Hong Kong securities laws. It is not new law, but it is valuable.
The key messages are as follows:
1) NFTs are growing in systemic relevance and the SFC is watching
In the SFC NFT Statement, the SFC acknowledges that NFTs “have increased in popularity”. This might appear as a fairly benign statement (which it is, legally speaking), but for those of us who look at regulation with a 5-year lens, it is important.
As we remarked in our report on Building a Legal Architecture for the Metaverse, the Financial Action Task Force (FATF) has earmarked NFTs as an area to watch in the area of anti-money laundering and counter-terrorist financing (AML/CTF). After all, if NFTs are (or represent) “property”, as is very commonly the case, then AML/CTF and sanctions laws already apply. The question is whether licensing and a prescriptive customer due diligence regime should also follow, aligning NFTs marketplaces and brokers with traditional banks and securities firms.
As NFT adoption and use cases grow, so too does the likelihood that the sector will be regulated in some way. However, this depends on whether there is evidence of misuse of NFTs to launder money, finance terrorists or evade sanctions. From an SFC standpoint, it also depends on the degree of perceived risk to consumers and where Hong Kong ultimately draws the line on how to regulate virtual assets (a summary of current proposals is here). In general, the trend line has been not to regulate – see below – but this is changing. Recent international enforcement cases such as the United States Department of Justice charges against an Open Sea employee alleging money laundering and wire fraud, signal that NFTs are not immune from incentivised authorities.
At this stage, we do not foresee all NFTs coming into Hong Kong’s financial regulatory net, but lines are being drawn.
2) The NFT ecosystem carries risk
The SFC highlights a number of risks to which NFTs are exposed, “as with other virtual assets”, including:
These are all fair observations. Indeed, there have been a number of lawsuits in the past couple of months relating to NFT issuances as widely dispersed as Singapore, Mainland China and the United Kingdom.
A few more we would add to this list include the following:
- Poor or non-existent contracts including vague, generic and “zero responsibility” terms and conditions.
- Inconsistent contracts – for example, hard coded smart contracts must be reflected in any natural language terms (eg in relation to perpetual royalties) to avoid any discrepancies between the legal contract for sale and the technological mechanism of transfer. Otherwise, contractual risks may arise.
- Unclear intellectual property (IP) rights – NFT descriptions regularly do not articulate precisely what is being sold; references to standard form licences provide very little clarity to inexperienced users.
- Reliance on own diligence, particularly in peer-to-peer NFT marketplaces. When paired with inadequate third party valuation mechanisms and an immature advisory market, this places a strong onus on individual participants to do their own homework and make sensible decisions as to their risk exposure.
- Insufficient practicable enforceability mechanisms, although this does not mean there are none. Key complexities include unnamed or unknown counterparties, unfamiliar governing laws and in some cases, clauses deferring to the decisions of an underlying decentralised autonomous organisation (or DAO).
- Custody risks, including a lack of trusted custody options regulated in home markets, with traditional custodians generally at an early stage of launching crypto-capable products, particularly for retail.
- Trade mark and copyright risks when NFT issuers leverage others’ brands.
However, these are not universal risks. We see very strong projects and clients with a commitment to robust documentation and the creation of higher quality curated markets. As such, we add to the SFC’s warning a recommendation to seek out quality players, because they do exist.
3) NFTs are generally not regulated in Hong Kong
The SFC acknowledges that most NFTs are not regulated in Hong Kong under the Securities and Futures Ordinance (Cap. 571). Specifically, the SFC states:
“The majority of NFTs which the SFC has observed are intended to represent a unique copy of an underlying asset such as a digital image, artwork, music or video. Generally, where an NFT is a genuine digital representation of a collectible, the activities related to it do not fall within the SFC’s regulatory remit.” (our emphasis)
Statements like these are helpful because they support industry certainty.
4) …but the facts matter
NFTs could, of course, represent anything – a bespoke option on shares, for example, which would still be a regulated security. Perhaps more “creatively”, we have seen fully-KYC’d account credentials for a crypto exchange offered as an NFT. These may be represented by a token, but they still involve fraud.
For its part, the SFC highlights two examples of digital collectible NFTs that may be financial assets and not mere (unregulated) collectibles:
- “Fractionalised” NFTs. While undefined by the SFC, this generally refers to NFTs that represent a part (fractional) interest in the relevant IP or other rights or assets to which the NFT pertains. An example might be an NFT that represents an interest in a highly valuable physical painting. That interest may rely on an arranger who purchases the painting and organises its shipment, insurance and perhaps a loan to a museum, as well as distributing profits to all interest holders on a future sale. That NFT would generally be an interest in a collective investment scheme (CIS), which is a security. On the other hand, it is possible to have different sets of rights (represented by unique NFTs) in relation to a single underlying asset without that resulting in a CIS. For example, one NFT may represent a personal licence to use a digital image; another may represent a commercial licence to use that same image.
- “Fungible” NFTs. A fungible non-fungible token is not really an NFT at all. However, the SFC may simply be referring to tradability, particularly on a secondary market. This has been a focus in a number of markets, particularly ones that carry a very broad definition of what constitutes a “security”. To be clear, secondary market tradability is not a part of Hong Kong’s definition of security, but it may factor into broader considerations such as whether a CIS exists. An alternative is that the SFC is merely intending to refer to NFTs in name only.
The SFC makes clear its concern relates to NFTs “structured in a form similar to “securities” …or in particular, interests in a [CIS]”. The rest of the SFC NFT Statement also makes clear that licensing and public offer requirements only apply where the usual statutory triggers apply. This emphasises the point that not all NFTs are regulated, but the facts matter.
We see genuine complexities arise for NFT issuers that seek to layer functionality over time or who wish to signal (or indeed manufacture) price appreciation. Gambling laws are also critical to consider here.
Global developments
NFT regulation remains at a very early stage internationally. The most prominent focus is taxation, with AML/CTF controls as an emerging theme appearing in guidance by the FATF (as noted above) and local regulatory circulars (including by Australia’s AUSTRAC as we reported here).
Having said that, the global landscape for virtual assets is changing at a very fast pace, with a significant number of new virtual asset service provider (VASP)-related laws being implemented globally. In our experience, new regimes tend not to attach to all NFTs, particularly if they are intended as blockchain representations of a person’s ownership or control of a (non-fractionalised) “real-world” asset or digital work. However, much depends on analysing the specific features of the NFT and how it is marketed and sold.
In addition, given the significant uptick in NFTs and NFT marketplaces, we are seeing a number of developments from our reviews, including the following:
- Exemptions to new VASP laws being narrowly defined. This makes the analysis of an NFT and its surrounding ecosystem important.
- Custody and safekeeping laws being engaged. This is particularly the case in closed-loop structures where NFTs do not “leave” an ecosystem or in which an entity (or group) is involved in key management.
- Regulators imposing restrictions on their regulated entities. For example, Thailand’s Securities and Exchange Commission issued a new regulation in June 2021 prohibiting locally licensed virtual asset exchanges from listing “meme tokens”, “fan tokens”, NFTs or those issued by the exchange itself.
- New laws being proposed. For example, Japan – an early mover on virtual asset regulation globally – has signalled through the Financial Services Agency that it could introduce new laws that could extend to NFTs, with both the aim of consumer protection and promotion of innovation. Further, in the United States, a new bill to regulate virtual assets has sought to provide greater certainty regarding the treatment of transactions in respect of genuine virtual collectibles and other unique virtual assets.
- Warnings being issued, particularly in relation to taxation and AML/CTF misuse, as noted above.
- Some markets implementing mechanisms to support the sector. For example, Liechtenstein’s Token and Trustworthy Technology Service Provider Act 2019 provides a statutory regime for recognising “digital twins” – that is, the tokenisation of assets and interests through their representation in digital form.
- Litigants testing the boundaries of elastic existing laws. For example, we are aware of the United States litigation involving Dapper Labs and its NBA Top Shots and related allegations that securities law may have been violated. To a large degree, this involves the combination of very broad and elastic conceptualisation of “securities” as well as how NBA Top Shots have allegedly evolved and been marketed and sold.
Conversely, some jurisdictions that are commonly considered as “off limits” for virtual assets that are utility or payment tokens, may not necessarily be fully prohibitive for NFTs. Many jurisdictions’ laws have extra-territorial reach, usually extending to marketing activities targeting local market participants. Some laws are more stringent, applying where local residents are involved, irrespective of marketing.
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Please contact us if we can assist you with any NFT, virtual asset and Metaverse initiatives. We would be delighted to help.
